The Coming Deflation Scare

In the 5th January Interim
Update we said: "...if the various markets do roughly
what we expect them to do then another big deflation scare is
probably on the cards for 2005-2006. In particular, if a) gold
and gold stocks experience normal mid-cycle corrections over
much of this year, b) the stock market peaks during the first
quarter of this year and then declines into the next 4-year cycle
bottom (due in the second half of 2006), and c) commodities trend
lower between the second quarter of this year and the third quarter
of 2006 in synch with reduced global growth expectations and
a strengthening US$, then deflation fears will once again begin
to dominate the financial landscape. However, it's a very good
bet that the end result of the 2005-2006 deflation scare will
be the same as the result of every other perceived deflation
threat of the past 70 years -- more inflation, one of the main
effects of which will be currency depreciation."

We are now into the fourth
month of the year and at this stage the financial markets are
doing roughly what we expected them to do, that is, the story
is unfolding in a way that makes another big deflation scare
a likely prospect within the next few quarters. As mentioned
in previous commentaries, these deflation scares are quite useful
as far as the Fed is concerned because they provide the justification
for more inflation. In fact, inflation confers no benefits whatsoever
-- not even the transitory kind -- if the public recognises the
inflation problem and takes action to protect itself. However,
when most people are unconcerned about inflation or believe deflation
to be the bigger threat then the Fed is free to inflate to the
fullest extent of its powers. That the Fed retains this freedom
to inflate is critical because for every dollar in the world
there are several dollars of debt, the result being that inflation
is the lifeblood of today's monetary system. Or, putting it another
way, the current monetary system is effectively the world's largest-ever
"Ponzi scheme" in that new money must be continually
brought in to allow earlier obligations to be met.

The main difference between
genuine deflation and a deflation scare is that the former is
a contraction in the total supply of money whereas the latter
is a psychological reaction to falling prices. In particular,
although a fall in prices that is not preceded by a reduction
in the total supply of money has absolutely nothing to do with
deflation, many people wrongly think that falling prices and
deflation are one and the same. Therefore, whenever there's a
broad-based sell-off in the commodity markets the idea that the
country is headed towards deflation becomes popular and the call
goes out to the Fed to inflate-away the looming threat. The Fed
then answers the call even though genuine deflation was never
a serious threat in the first place.

If a deflation scare did eventuate
it would likely have short-term bullish implications for the
dollar and bearish implications for gold. The reason is that
inflation expectations would almost certainly start to fall BEFORE
the Fed had completed its rate-hiking campaign, meaning that
there would be a brief period -- a few months, perhaps -- when
real US interest rates** were
rising quite sharply. However, gold would likely begin its next
major advance as soon as the market sensed that the Fed, in response
to the deflation scare, was about to shift from a modestly restrictive
monetary stance to an extremely loose one.

As far as the debt markets
are concerned, the thing we can say with the greatest amount
of confidence is that the outcome of a deflation scare would
be a flight to quality. In other words, a highly probable outcome
would be an across-the-board widening of credit spreads (under-performance
by emerging market debt relative to US Treasury debt, high-grade
corporate debt relative to US Treasury debt, and low-grade corporate
debt (junk bonds) relative to high-grade corporate debt). We
can also confidently predict that the Fed would make an about-face
soon after the markets began to agonise over the prospect of
deflation. In fact, the way things are panning out there's a
good chance that the next official rate-CUTTING campaign will
begin before year-end.

Although US Treasury bonds
would likely perform well relative to almost all other bonds
during a deflation scare, we don't have a strong opinion on how
they would perform in absolute terms. A lot, we suspect, will
depend on what the market does over the coming 2-3 months. A
sharp sell-off in the T-Bond market during the next couple of
months, for example, would set the scene for a powerful rally
over the remainder of the year.